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Thursday, August 23, 2007

An Brief Empirical Look at the 'Past Monetary Profligacy' View

A common refrain found in the ongoing discussions surrounding the current market volatility is that we are bearing the consequences today of past monetary profligacy. Dropping the federal funds rate to 1% and holding it down for so long over the past few years has been cited by many observers as being distortionary, particulary in the housing sector. Although some observers such as Mark Gertler of NYU--a longtime buddy of Ben Bernanke--discount these claims, I believe there is enough evidence to take these claims seriously.

One bit of evidence for past monetary profligacy often cited by the Economist is that during this alleged time of profligacy the nominal federal funds rate was below the nominal growth rate of the U.S. economy. In other words, the rate of return of investing in America Inc. exceeded the cost of borrowing. Consequently, it was a no brainer that there would be excessive leverage. The above graph examines this claim. This graph plots the year-on-year growth rate of nominal GDP minus the nominal federal funds from 1975 through early 2007--the policy rate gap for short. By this metric, the alleged period of monetary profligacy is evident by the inordinately-sized spike in this series that looks like an inverted V for the years 2001-2007. The large size of the policy rate gap during this time does suggest monetary policy may have been too easy. Also plotted on this graph is the year-on-year growth rate of the OFHEO housing price index adjusted for inflation and lagged by 1.5 years. Interestingly, the surge in real home prices of the last few years appears to have been related to the surge in the policy rate gap between 2001 and 2005.

The next graph takes the policy rate gap and the real housing price growth rate and plots them against each other in a scatter plot. This graph indicates there is indeed something systematic occurring between these two series. Running a regression produces a relationship that is statistically significant (p-value of 0.000) with a R-squared of 30%. A non-trivial amount of the variability in the real housing price growth rate then can be explained by the policy rate gap. This analysis indicates the Economist was on to something after all and that there does appear to have been monetary profligacy.

Another point made by many observers, including myself, is that the deflation scare of 2003 that prompted the Federal Reserve to lower rates all the way down to 1% appears in retrospect to have been particularly distortionary. A standard result in most growth models is that the natural rate of interest is determined by the productivity growth rate, individuals intertemporal preferences, and the population growth rate. If the latter two factors are relatively stable, then changes in productivity should be reflected in similar changes in the interest rate in order to avoid the formation of financial imbalances. For example, if the productivity growth rate increases then there should be some nudging up of the real interest rate as well. However, if monetary authorities step in and push the real interest rate beneath the productivity growth rate they have set the stage for a classic Wicksellian disequilbria. The above graph provides evidence the Federal Reserves response during the deflation scare of 2003 was indeed creating just such a distortion. Part of the problem was that the Federal Reserve failed to account for the possibility that the deflationary pressures of this time could have come from the robust productivity growth depicted in this graph. This suggest the Federal Reserve needs to hone up on its ability to distinguish between malign and benign deflationary pressures (see William White's article "Is Price Stability Enough" for a good primer on these distinctions).

Although brief, the evidence posted here does lend support to the view that we are paying the price today of past monetary profligacy. My hope is we learn from these experiences moving forward.